The common wisdom is to select an LLC for a new business. That wisdom needs to be scrutinized. Sure forming an LLC is easy. Generally, the filing fees are less than a corporation, and the documentation is less complicated.
While the LLC may remain the best choice for an investment, it can create issues for an operating business. With the corporate tax rate now only 21%, the tax advantages of an LLC have diminished. Yes, in early years the LLC is likely to generate losses, which can flow through to the owners but this flow through status can cause headaches down the road. For example, employees in corporations are often given stock options. In an LLC employees might be given “profits interests,” which means they start to participate when the founding owners are paid back. The problem is that the profits interest will have to be valued upon receipt. Intangibles, etc… are hard to value. The LLC may not have the resources to provide a professional appraisal or they may not even be aware of the issue. If the LLC become valuable, the IRS will have to benefit of hindsight in valuing the profits interest and the employees may have no evidence to counter the IRS with. The result could be a huge tax surprise for the employees. In addition, the IRS treats all of the owners as partners, which means they will receive a K-1 from the LLC, which will disclose financial information about the LLC. Also, each owner is responsible for their own tax withholding payments.
Finally, as a general rule, private equity and venture capital prefers to invest in corporations rather than pass-through structures. This is because those entities are typically flow through entities and they don’t want the income or loss of their investments to flow through to their limited partners. This might require their limited partners to pay tax on the income and file a return. Filing a return creates an additional audit risk they would prefer to avoid.
Again, the type of business will have a significant influence on the legal structure. Just keep in mind it isn’t as easy as LLC.
